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New Government Policy in China Has Real Implications for Global Economy

China's economy is growing more slowly than many observers had expected. Gross domestic product (GDP), the broadest measure of economic activity, grew by 7.5% in the second quarter, down from 7.7% in the first quarter of 2013. GDP growth in China could slow even further, as 7.5% growth is being anticipated for all of 2013 — which would be the country's lowest annual growth rate since 1990.1

This slowdown has generated concern among economists and investors that China's robustly growing economy, which had been posting double-digit growth rates under the former Premier Wen Jiabao, is headed for a "hard landing" as China faces pressure from higher production costs, slowing infrastructure investment and growing financial sector stress.

If a hard landing were to occur, it could have a negative impact within China on real estate prices and could lead to a potential surge of nonperforming loans in its banking sector. At the same time, a slowdown in the Chinese economy could negatively affect the rest of the world through exports, commodity prices and financial markets.

The Chinese economy is at a crossroad

The previous policies of the Wen administration, which included a $586 billion stimulus program in 2009, were focused on supporting further economic growth and expansion at the expense of adding to economic imbalances, the consequences of which are being felt today.

But as the economy slows, the new government under Premier Li Keqiang has an opportunity to pause and take stock of what kind of economic policies are necessary to promote a more balanced and sustainable approach to long-term economic growth. Policies that aim to reduce Chinese reliance on exports and foreign investment by promoting growth through energy-efficient technology and greater consumer spending, for example, could be key factors in such future growth prospects. However, in the near term such policies could result in slower growth, reducing the likelihood that China will begin producing double-digit growth rates again anytime soon.

Implication of new government priorities for off-balance sheet and nonbank lending

As China's new government seeks to create a more market-oriented economy focused on sustainable long-term growth through structural reforms, one casualty may be the booming business of nontraditional credit, also known as "shadow banking." Until recently, this type of off-balance sheet intermediation provided lenders and borrowers some flexibility in China's otherwise strict official lending environment.

Such lending, broadly known as "total social financing," averaged 1.692 trillion yuan ($273 billion) in the first six months of 2013, an increase of 280% from 679 billion yuan ($97 billion) generated during the first six months of 2008.2,5 Moody's estimates that core shadow banking products totaled 21 trillion yuan at the end of 2012, representing 39% of China's GDP last year.3

This scope of activity has raised concerns about the amount of leverage and systemic risk in China's banking system. Local governments, for example, set up more than 10,000 Local Government Financing Vehicles (LGFVs) to fund the construction of roads, sewage plants and other infrastructure projects after a1994 budget law prohibited them from directly issuing bonds.2 These LGFVs are due to repay a record amount of debt this year. Moody's anticipates that a local government default could occur this year as 127 billion yuan ($21 billion)4 in LGFV notes will mature in the second half of 2013. Barring any preventative action by Premier Li, it would mark China's first onshore bond default.5 In an effort to mitigate these risks, the State Council ordered the National Audit Office to determine the extent of overborrowing by local governments that were using shadow banks, and a cash crunch was engineered in June by the People's Bank of China (PBOC) to target such lending practices by withdrawing liquidity from the interbank market raising the cost of borrowing dramatically.

However, there is a real possibility that the engineered liquidity crunch could worsen the country's economic contraction and potentially add to greater stress in the property and infrastructure sectors. For example, banking system nonperforming loans, which are reported at approximately 1.0% of total loans,6 could face significant upward pressure if economic growth continues to slow and lending becomes restricted.


In his current actions, Premier Li is acknowledging the risks brought on by the country's past credit boom and is clearly showing restraint in following the same actions as his predecessors to spur growth. The PBOC's recent actions and other reforms being presented by the new administration are designed to make over China's robust economy — this time with increased investment efficiency, which is critical to the long-term health of the country's financial system.

1 Source: Bloomberg, L.P.
2 Sources: Bloomberg L.P., as of July 29, 2013
3 Source: Moody's Investors Service. "Risks to China's Lenders from Shadow Banking: Frequently Asked Questions." May 13, 2013
4 Source: Moody's Investors Service, Risks to China's Lenders from Shadow Banking: Frequently Asked Questions, May 13, 2013
5 Source: Moody's Investors Service, Risks to China's Lenders from Shadow Banking: Frequently Asked Questions, May 13, 2013
6 Source: People's Bank of China

About Risk

China remains a totalitarian country with the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China's dependency on the economies of other Asian countries, many of which are developing countries.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Defaulted securities involve the substantial risk that principal will not be repaid and may be subject to restrictions on resale.
Leverage created from borrowing or certain types of transactions or instruments may impair the fund's liquidity, cause it to liquidate positions at an unfavorable time, lose more than it invested, increase volatility or otherwise not achieve its intended objective.
The prices of and the income generated by securities may decline in response to, among other things, investor sentiment, general economic and market conditions, regional or global instability, and currency and interest rate fluctuations.
Shadow Banking is defined as credit intermediation involving entities and activities outside the regular banking system. (Financial Stability Board) This is important because it Shadow Banking allows borrowers to obtain financing from alternative sources and circumvent banks' formal underwriting standards.
Total Social Financing began in 2011, the Peoples Bank of China began defining TSF as an overall indicator of the size of social financing = RMB-denominated loans + Foreign currency loans + consignment loans + trust loans + Bank's Acceptance bills + Corporate bills + Stocks of non-financial enterprises + Insurance claims + Property investment by insurance companies + Monetary increase of other natures within a given period. TSF covers all markets (loan and credit, bonds, equities, insurance and intermediate markets) and can better reflect the amount of capital support to the real economy given by financial institutions via capital operation.

The opinions expressed herein are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. As with all investments there are associated inherent risks. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.

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